Inflation

Inflation is a general rise in prices — not all prices, some prices may even fall, but most prices. In the United States, inflation is measured by the Consumer Price Index (CPI), which is the rate of inflation as measured by the ratio of the consumer price index of one year over the base year or some other reference year. This result is then multiplied by 100 to yield an accurate integer representation of the index. Hence, the consumer price index is calculated much like the GDP deflator.

Types of Inflation: Demand-Pull Inflation and Cost-Push Inflation

There are 2 types of inflation that are distinguished by cause: demand-pull inflation and cost-push inflation.

Demand-pull inflation occurs when an increase in spending outstrips the increase in economic output, when aggregate demand exceeds aggregate supply. Oftentimes, demand-pull inflation occurs when the money supply increases faster than the economy. This shifts the demand curve rightward, causing prices to rise for every level of output.

As the economy grows, the money supply must increase proportionately. If the money supply grows too fast, then inflation results; if it grows too slowly, then deflation results. Inflation not only depends on the supply of the money stock, which is the quantity of money, but also depends on how fast people spend it, which is often referred to as the velocity of money. For an economy, the velocity of money is simply equal to the value of all transactions divided by the value of the money stock. For instance, if grandma wins a one million-dollar lottery, takes it as a lump-sum payment, then goes home and stuffs it in her big mattress, then it will have no effect on the economy. It will be as if the money never existed. In this case, the money supply actually decreases, since $1 million has been taken out of circulation. This would have a contractionary effect on the economy, albeit a minor one for a $15 trillion economy.

Although central banks control the availability of credit and the money stock, they cannot control the rate at which people spend the money. Sometimes, the money supply is increased by the easy availability of credit. One of the best illustrations of demand-pull inflation occurred during 2003-2007, when real estate prices exploded, because banks started giving loans to anyone who could breathe. The mortgages were packaged into mortgage-backed securities, which the banks then sold to investors, passing along the credit default risk of the mortgages to the investors. This took the mortgages off the banks' balance sheet, allowing them to make even more loans, which they did because they profited from the origination and servicing fees for the loans. This continual process increased demand much faster than the supply could increase, so demand-pull inflation resulted.

As long as the increase in economic output is greater than the increase in the money supply, there will be no demand-pull inflation. As long as firms have idle capacity, increases in spending will cause the firms to use up their capacity before raising prices. However, as the economy nears full employment, and idle capacity becomes used up, it becomes increasingly difficult to increase output, so prices rise. The marginal cost of producing extra product increases substantially as the limits of fixed capital are reached, so businesses must raise prices to remain profitable.

Generally, some demand-pull inflation is good because it indicates that the economy is closer to full output and that the unemployment rate is at its natural rate. This increases both economic growth and prosperity, which central banks try to maintain by allowing the money supply to grow only as fast as the economy. This keeps demand-pull inflation in check.

Sometimes inflation is caused by increases in the cost of inputs, or the factors of production, which gives rise to cost-push inflation. However, cost-push inflation does not occur as frequently as demand-pull inflation, especially in less developed countries, where politicians are inclined to solve monetary problems by printing more money, a major cause of demand-pull inflation in those nations. Cost-push inflation arises as the per-unit production costs increase.

Per-unit production cost is equal to the total input cost divided by the units of output.

Because businesses want to make a profit, as per-unit production costs increase, businesses raise their prices, even while output and employment are decreasing. Such was the case in the 1970s when the price of imported oil nearly quadrupled in 1973 – 1974 and rose sharply again in 1979 – 1980. Such major sources of cost-push inflation have sometimes been referred to as supply shocks.

Sometimes it is difficult to distinguish between demand-pull and cost-push inflation – it is even possible that both causes of inflation are operative. However, demand-pull inflation will continue as long as the money supply increases, whereas cost-push inflation is self-limiting, because higher prices reduce demand when the money supply is not increasing.

Cost-push inflation generally decreases output. When the Organization of Petroleum Exporting Countries (OPEC), quadrupled the price of oil in 1973 to 1975, economic output declined dramatically, and the unemployment rate rose from 5% in 1973 to 8 .5% in 1975.

Redistribution Effects of Inflation

Different groups of people are affected differently by inflation, but to determine who those groups will be, it is helpful to distinguish between nominal income and real income. Nominal income is the actual number of dollars of income received by individuals, households, and businesses. Real income is equal to the purchasing power of those dollars.

Real Income = Nominal Income/Price Index (in hundreds)

Obviously, if people's nominal income rises at the inflation rate, then their real purchasing power remains the same. However, when nominal income does not increase as fast as the inflation rate, then people suffer.

A change in real income is equal to the percentage change in nominal income minus the percentage change in the average price level. So if nominal income rises by 5%, but the inflation rate is 6%, then real income will decline by 1%.

Some people are unaffected by inflation. People who receive incomes that are adjusted for inflation, such as social security, or when union workers get automatic cost-of-living adjustments (COLAs), which raises pay according to some percentage of the CPI, will largely be unaffected by inflation.

Generally, those people who are hurt by inflation are generally people who receive income at a fixed interest rate. This includes retirees, who may depend on a fixed pension or annuity income, savers who have bought bonds, or who have savings accounts or certificates of deposit, and creditors, who often lend money at a fixed rate of interest. Higher inflation will reduce the value of money over time. If the inflation rate is higher than the interest rate, then the actual purchasing power of the money received by those who are receiving this fixed interest income will decline.

Many of the effects of inflation depend on whether it is anticipated or unanticipated. Anticipated inflation causes people to counteract the consequences of the higher inflation rate. For instance, unions will ask for higher pay raises and workers will also demand higher pay raises. However, unanticipated inflation causes people to lose purchasing power – their real income declines, because it takes time to recognize the inflation.

The main effect of anticipated inflation is that people who lend money will demand a higher interest rate for their loans to compensate for the loss of the purchasing power of their future cash flow. Generally, lenders increase the rate of interest they charge by what is called the inflation premium, which is the interest rate that covers the expected rate of inflation. So if a lender thinks that a 6% return is a fair return, and the inflation rate is 3%, then the lender will seek a 9% interest rate on its loan.

Some people benefit from inflation. Debtors are the main beneficiaries of inflation, for they borrow more valuable money than the money they will use to pay back the loan. The longer the term of the loan, the greater the difference between the purchasing power of what was received with what was paid back. Hence, although the federal government is deeply in debt because of the recent credit crisis, its borrowing costs are very low, maybe even lower than inflation, which makes the present state of the United States not nearly as dire as some suggest.

Like income, interest rates can also do be divided into nominal interest rates and real interest rates. A nominal interest rate is the increase in the nominal value of the principal, while the real interest rate is equal to the increase in purchasing power of the principal. Therefore:

Nominal Interest Rate = Real Interest Rate + Inflation Premium

Deflation

Deflation results when there is a general decline in the price level. Hence, the beneficiaries of deflation are the opposite of those who benefit from inflation. People receiving interest based on a fixed interest rate will see their purchasing power increase over time; likewise, for creditors. Even people who save cash will earn a return during deflation, because the inflation premium is now negative. However, people with physical assets, such as real estate, will suffer. The Japanese economy is a good illustration of what happens during deflation. Because money increases in value as prices drop, people hoard their money, which causes the economy to contract, thereby causing prices to drop even more into a deflationary spiral.

However, deflation hurts debtors, because they pay back money that is more valuable than the money they received, even if no interest rate was charged.

Hyperinflation

When inflation becomes extreme, hyperinflation is the result. This most often occurs when the government tries to solve fiscal problems by printing more money. When the economy starts to recognize hyperinflation, people and businesses start buying hard assets to protect their income. However, most of these assets, such as gold, collectibles, and even real estate, do not produce output. Time and effort is spent in trying to profit from the inflation or to prevent its ruinous effects, but these efforts have no economic value, since they do not result in increased output.

Furthermore, people have increasing difficulty knowing what normal price should be. Likewise, businesses cannot be certain at what price they should sell their products and services, since their cost for new materials and other input such as labor, may rise substantially in a short time.

Because money loses value quickly in a hyperinflation, people spend the money as fast as they can, which increases the money supply even further, because the velocity of money is accelerated.

The end result of most cases of hyperinflation is that the economy starts using hard assets, such as gold or silver, for money, or, as is more often the case, the economy starts using a foreign currency, which is known as dollarization, because most of these economies in the past have turned to the United States dollar. Then the government loses control over the economy, and the economy becomes dependent on the availability of foreign currency or hard assets.